Complacency at the Fed

This post was written by Julius Probst, Phd Student in Economic History at Lund University.

It has become increasingly clear over the last few months that the Fed has tightened monetary policy considerably. Inflation expectations as measured by TIPS spreads have decreased significantly, asset prices have collapsed over the last couple of months, and most importantly, quarterly nominal GDP growth has also been on a downward trend for more than a year (see graphs 1-3 below).


With 10-year inflation expectations being at a new record-low after the financial crisis (see graph 1), financial markets now assess that the Fed will hike rates only once this year.


The Federal funds future market suggests that the Federal funds rate will be at most 0.5 percent if not lower by the end of 2016. Again, we see that market expectations about current and future economic conditions and the assessment of the Fed are increasingly out of sync. Just shortly ago Fed officials announced that the Fed will probably hike rates 3-4 times over the course of this year.


This is hopefully not going to happen now as it has become quite clear that the Fed’s rate hike in December was a tremendous mistake. Monetary policy tightened already quite considerably beforehand and the Fed’s move simply aggravated the situation.


Economists like Krugman and Summers warned in the end of last year that the Fed’s rate hike is ill-advised and that the risks were highly asymmetric, but it seems like Fed officials put themselves into a tight spot. They announced by the middle of 2015 that they would move away from the zero-lower bound by the end of the year and they considered it a mistake to back off.


Obviously, this course of action seems rather strange. As new information comes in, a change in policy seems to be the normal thing to do and would rather lead to an enhancement in credibility instead of a loss in credibility if the new policy course is more consistent with the Fed’s target of full employment and price stability.


Inflation expectations as measured by TIPS spreads show that the Fed seems to be quite a bit off course. Both actual inflation as well as inflation expectations have continuously drifted downward and financial markets now think that the Fed will undershoot its inflation target of 2 percent for another decade.


As I have already mentioned previously, past experience since the beginning of the crisis has shown that financial markets mostly got it right when it comes to economic forecasts while policy makers usually got it wrong. Fed officials have consistently overestimated the strength of the recovery and thus policy can often be described as “too little, too late”. Tight monetary policy during the acute phase of the financial crisis as well as more recently has led to a considerable loss in output and employment. Millions of people had to bear the costs of an extremely weak labor market because policy makers pursued ill-advised policies. This phenomenon, of course, is not US-specific. In fact, both the Swedish Riksbank as well as the ECB have also been critizised for pursuing extremely tight monetary policies over the last years.


David Glasner explains how the recent decline in inflation expectations is a serious cause for concern. As the return of holding cash increases with lower inflation rates, a perverse Fisher effect kicks in. Asset prices must collapse as to equalize the return between holding cash and other assets such as stocks. In the worst-case scenario, a deflationary spiral can unfold with crashing asset prices and declining economic activity until the economy reaches a new equilibrium.


The financial crisis has shown forcefully how such a disequlibrium process in which the economy is in free fall is extremely nasty. Moreover, the period of economic stabilization thereafter might be consistent with extremely high levels of unemployment. It has taken more than 7 years for the economy to return to an unemployment rate of 5 percent, which is generally considered by policy makers as the natural rate of unemployment nowadays.


In this light the decision of the Fed in the beginning of this year to leave policy unchanged is more than strange. As mentioned above, financial markets have been in turmoil since January and general economic activity seems to have slowed down considerable. Furthermore, the probability of a US recession has increased significantly and is estimated to be at about 30% by Larry Summers.


However, the Fed doesn’t seem to agree. Officials at the Fed think that inflation will soon pick up as the labor market tightens and the natural rate of unemployment is reached. Yellen & Co. thus seem to believe that slack in the labor market is negatively related to the inflation rate. As Lars Christensen has put it recently, the current Fed seems to operate as if they believe in a crude version of the old-fashioned Keynesian Phillips Curve of the 1970s, which suggests a negative relationship between the unemployment and the inflation rate. As slack in the labor market disappears, inflation is supposed to pick up.


New Keynesian macroeconomics, however, is somewhat skeptical about this proposition. Indeed, the negative relationship between slack in the labor market and inflation only holds up in the case of demand shocks. The following exposition is based on basic New Keynesian macroeconomics. The graph below is straight out of the textbooks, so one really has to wonder why the officials of the Fed do not seem to show more awareness to the current dire macroeconomic conditions.

The graph displays the standard aggregate demand - aggregate supply framework (AD-AS). Now let’s assume that the economy starts in equilibrium with full employment and an inflation rate consistent with the Fed’s official target of 2% (point A in the graph).


A large negative demand shock or a series of negative demand shocks will shift the AD curve to the left. The economy will move along the short run aggregate supply curve from point A to point B. That is of course conditional on the fact that the Fed does not immediately offset the demand shock.


Obviously, Central Banks should pursue policies that respond immediately to large aggregate demands shocks. An optimal policy would offset the shock right away by not allowing crucial variables like unemployment and inflation to deviate from their target, but if the last years have taught us anything it is that Central Bankers do not always live up to their role.


As the economy moves from point A to B output declines, unemployment rises and inflation falls. In this particular scenario the inflation rate is negatively correlated with slack in the labor market until the economy reaches its new equilibrium at point B. Eventually the economy will return back to full employment even if the Central Bank does not offset the negative demand shock. More specifically, the economy will move along the AD curve from point B to point C as the short-run aggregate supply curve shifts to the right. One should notice that the inflation rate now actually falls even as the economy moves closer towards full employment. 

Inflation and slack in the labor market as measured by unemployment are now positively correlated, which is exactly the opposite than what the traditional Phillips curve suggests. In the new equilibrium at point C, the inflation rate at potential output will be lower than before. Note that the US economy has displayed a pattern extremely similar to the one I just have described. The inflation has continuously drifted downward over the last couple of years even as unemployment has approached its natural level (see graph 5).


The aggregate demand - aggregate supply framework suggests that full employment can be consistent with a large number of possible inflation rates. It is the Central Bank that determines the height of the AD curve, that is whether we have full employment at 1 percent, 2 percent or any other inflation rate in the long-run.


Of course, current macroeconomic conditions are somewhat more complicated than before the crisis. This, however, does not release the Fed from its obligations. The Fed is currently not constrained by the zero lower bound anymore. And even if it was, negative interest rates and Quantitative Easing are powerful tools that could guide the economy towards a higher inflation. It is therefore more than strange that the current Fed seems to be extremely complacent and remains extremely passive even though monetary policy has tightened significantly over the last months.